Thursday, May 7, 2015

Rising Yields on Treasury Bonds

We've seen a startling and unexpected move to higher yields on the UST 10-year over the past two weeks, with yields rising from 1.87% on April 17 to 2.24% on May 6. Market professionals are scratching their heads to understand the backup in rates amidst weak Q1 GDP, durable goods, factory orders and most recently, ADP private payrolls.

Much of the latest tantrum followed a prescient call by Bill Gross on shorting German BUNDs, for which those investors following his advice would have profited considerably. Soon to follow were prognostications by a variety of equity guys, including Warren Buffet, who while a demonstrated equity maven, might not be the best source of advice on bonds. Warren's a bit like your family doctor, who skilled in medicine seeks to give advice on a range of subjects beyond his expertise.

For his part, Warren is an old school cronie, not unlike John D. Rockefeller or J. P. Morgan, who built fortunes on the intersect of politics and business. But a bond trader, not so much. Equity guys fail to understand how bonds trade or the simple fact that bonds, unlike stocks, have terminal value.

For those who make their living in the sector, bonds trade on price, not yield. The price reflects the ownership of a stream of future cash flows. As robust economic activity and the prospect of inflation discount the value of those cash flows, bonds diminish in value. Conversely, weak economic growth creates value. In the deflationary world that Bernanke so feared, bonds would scream.

All of which is to say, the weak level of recently reported economic fundamentals argues that the current tantrum may not have legs and, at least in this one instance, an investor might profit by taking the other side of Warren's trade.